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In fixed income, choosing fundamentals instead of latest trends

By
Roger A. Early, Zoë Bradley

April 29, 2015

The bond market, despite being well established and diverse, is not one to rest on its laurels. It offers countless types of instruments to meet a wide range of objectives, and it would seem to be in little need of new types of securities. Yet the flicker of innovation is there in the background. In this case, however, innovation may not always be a good thing.

What exactly does “financial innovation” mean in the realm of fixed income?

In this context, financial innovation generally involves seeking to enhance a risky security by dramatically lowering its risk profile. One well-documented example is to take a corporate bond, bolt on a credit default swap,1 and market it as a security that has been stripped of credit risk. Other examples include debt instruments that use derivatives but nevertheless carry a strong credit rating. (A major investment bank brought these to market in 2014.)

Such modifications are not an entirely new art form. Many observers will recall the dubious period between 2007 and 2008, when subprime mortgage bonds were given investment grade ratings based solely on insurance wrappers that were a fixture in the mortgage-backed bond market at the time. When the housing market collapsed, the so-called monoline insurers who wrote those contracts fell under tremendous pressure. As defaults soared on subprime and adjustable-rate mortgages, monoline insurers were unable to keep up with the resulting claims, with several high-profile companies posting heavy losses and suffering downgrades to their stocks. For some insurers, the ultimate result was bankruptcy. The securities backed by the insurance policies were subsequently downgraded, and in extreme cases they became nearly worthless.

After a spotty history, financial innovation returns

A tenuous track record has not suppressed the resurgence of unorthodox bond configurations. Low returns on cash, low yields on government bonds (see table below), and reduced confidence in monetary policy have been among the drivers of demand.

Chart 1: Yields on government bonds: Look out below

Source: Bloomberg.

The hunt for yield is motivated by investors who see very few options in front of them, especially when central banks around the world are pushing yields down. (And this squeeze on yields is probably going to get more complicated as the European Central Bank begins printing money for its quantitative-easing program.) In light of these circumstances, we can appreciate investors’ conundrum, as portfolios have been shocked by a collapse of interest income. This makes it easy to see why the search is on to replace traditional fixed income instruments with something that yields more. However, we believe that, for risk-aware investors, patience and due diligence should be more important than excessive reliance on securities that have been created synthetically and may behave unpredictably when markets are under duress.

We have reached a point at which the “reach for yield” is often accompanied by a mentality of yield at any cost. We believe this approach can degenerate into a risky, often self-reinforcing loop.

Rates likely not set to rise soon

To put a finer point on the stickiness of today’s low rates, we don’t believe Treasury rates are set for an appreciable rise in the near term, regardless of what actions the Federal Reserve may take. An enduring rise in rates would likely require the confluence of several factors, including:

stronger investment spending

less risk aversion

less personal saving (see chart below).

Today’s conditions indicate to us that such a scenario is unlikely to unfold in the near future. Throw in the effects of currency devaluations happening around the world, and it further diminishes the likelihood of such an outcome.

Chart 2: Personal saving is back above trend

Though it hasn’t reached precrisis levels, consumer saving (as a percentage of disposable income) has climbed back above its long-term average.

New is not always better

We think most fixed income innovations stand a slim chance of meeting the same degree of safety and reliability found in traditional bonds with lower risk profiles. Newfangled bonds may offer the potential for greater total returns in isolated cases, but their added risks should be thoroughly scrutinized. All in all, we think it’s important to remember, as mentioned above, that many financial instruments that are overly engineered have a history of failing to deliver on their promises.

Investment ramifications

We think today’s low-yield conditions call for a diligent, responsible approach to uncovering sources of income. The fixed income landscape is home to a wide variety of possibilities, and our investment team has the resources and expertise to sort through them. Generally speaking, we believe in avoiding the use of “manufactured” offerings as core holdings, focusing instead on more-traditional positions that assist in managing overall portfolio risk and help us prepare for the ever-present likelihood of volatility spikes. All along, we think it makes sense to focus on our long-standing goals of preserving capital, maintaining responsibly diversified portfolios, and maintaining competitive yields.

When it comes to allocating assets across the portfolios we manage, we continue focusing on fixed income sectors that can absorb interest rate moves better than others. This often includes investment grade and high yield corporate bonds, levered loans, and international debt; all four can offer a degree of insensitivity to shifting rates. Aside from such sector-level inclinations, we are also looking at specific fixed income instruments that can contribute to our accommodative stance. Interest rate futures and premium coupon bonds2 are two examples that we think can be helpful in managing interest rate risk.

It all revolves around research

Whether making higher-level strategic decisions or looking at short-term tactical possibilities, we rely on a foundation of bond-by-bond research. By employing a rigorous course of analysis and scrutiny, our investment process centers on identifying each holding’s intrinsic value. We believe this is the best path to follow when accommodating a changing, dynamic, and sometimes “innovative” fixed income market.

1A credit default swap is a financial instrument that essentially provides protection against a bond issuer’s default. It is sold between two parties. Having agreed on a bond to “insure,” the buyer of the swap agrees to make periodic payments to the seller, and the seller promises to pay a fixed sum to the buyer if the bond does indeed go into default.

2Premium coupon bonds are issued with relatively higher coupons than their peers, which helps lessen their duration.

The views expressed represent the Manager's assessment of the market environment as of April 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 877 693-3546. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Diversification may not protect against market risk.

Fixed income securities can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder a issuer’s ability to make interest and principal payments on its debt.

Roger A. Early biography

Roger A. Early, CPA, CFA

Roger A. Early is global co-head of the firm’s fixed income team. He rejoined Macquarie Investment Management (MIM) in March 2007 as a member of the firm’s taxable fixed income portfolio management team, with primary responsibility for portfolio construction and strategic asset allocation. He became head of fixed income investments in the Americas in February 2015. During his previous time at the firm, from 1994 to 2001, he was a senior portfolio manager in the same area, and he left the firm as head of its US investment grade fixed income group. In recent years, Early was a senior portfolio manager at Chartwell Investment Partners and Rittenhouse Financial and was the chief investment officer for fixed income at Turner Investments. Prior to joining the firm in 1994, he worked for more than 10 years at Federated Investors where he managed more than $25 billion in mutual fund and institutional portfolios in the short-term and investment grade markets. He left the firm as head of institutional fixed income management. Earlier in his career, he held management positions with the Federal Reserve Bank, PNC Financial, Touche Ross, and Rockwell International. Early earned his bachelor’s degree in economics from The Wharton School of the University of Pennsylvania and an MBA with concentrations in finance and accounting from the University of Pittsburgh. He is a member of the CFA Society of Philadelphia.

Zoë Bradley

Zoë Bradley biography

Zoë Bradley

Vice President, Portfolio Analyst — Fixed Income Investments

Zoë Bradley is a portfolio analyst on the firm’s fixed income team. In this role, she serves as an investment specialist for the broad team, taking ownership of the team’s strategies and story, and managing communications with other areas of the firm. From April 2011 to April 2015, she was a dedicated portfolio analyst for the municipal fixed income portfolio management team. Prior to joining the fixed income investment team in April 2008 as a senior product manager, she handled product management and development for closed-end and fixed income funds at Macquarie Investment Management (MIM) for seven years. In this capacity, she was responsible for product development, assessing and determining market focus, competitive analysis, fund positioning, sales idea generation, and marketing material development for the product line. Bradley began her career with Delaware Investments in April 1997 in the retirement services department, and she has also served the firm as a product specialist for electronic commerce and as a relationship manager in the key accounts departments. She earned her bachelor’s degree in political science from Lycoming College.

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